Bonds explained: part 1

Bonds form a significant part of many investment portfolios and can often make up the majority of holdings in some lower risk portfolios, yet many investors know little about them.

At Schroders Personal Wealth we believe it’s important for people to be as informed as possible about the investments they hold. So we have written a three-part educational series that explains bonds in as simple language as possible.

This series is written in a Q&A format and attempts to cut through the jargon to help you understand what bonds are and how they work. This first part is relatively straightforward, covering what a bond is, why bonds are considered less risky than shares, and how they’re affected by interest rate changes.

Bonds are really complex, aren’t they?

Yes and no.

In that case, could we start with the ‘no’ bit please?

Sure. A bond is a loan someone gives to a government or a company. The borrower pays the lender a rate of interest for the loan and repays the capital on the date the loan expires.

A bond is just a loan?

To be more specific, a bond is an IOU issued by a government or a company. When you buy a bond, you’re buying an IOU.

OK I get that. Why, then, can they be so complex?

Because they’re traded on the stock market, which, by the way, allows you to buy a bond part way through the period of the loan and sell it before the loan expires. The fact that they’re traded on the stock market means their prices and interest rate payments (called ‘coupon’ payments) are affected by economic and market factors.

Understood. So what kind of factors could make a bond go down in value?

A change in interest rates is the most obvious example. Let’s suppose you have a bond from the UK government. UK government bonds are known as ‘gilts’ and let’s imagine this gilt pays a 5 percent rate of interest. Let’s also imagine the rate of interest for both the Bank of England (BoE) and bank savings accounts is 5 percent. And let’s suppose you want to sell the bond but, before you do so, the BoE raises interest rates to 6 percent and the rate of interest on savings accounts goes up to 6 percent too.

In this case, no one would buy your gilt, because they could get a higher interest rate from a savings account than from your bond. But if you reduced the price of the gilt so it now offers an effective 6 percent interest rate, then you would be able to sell it. In this example we would say the yield on the gilt has risen from 5 percent to 6 percent while the price of the bond has fallen.

So bond prices fall when bond yields rise?

Exactly!

And bond prices rise when bond yields fall?

Quite so.

And this bond’s price would go up in value if the BoE reduced its rate to 4 percent?

Yes. But sometimes the price of a UK government bond will rise or fall even when the BoE leaves its interest rate unchanged.

How could that happen?

The price could rise if, for example, investors expect the government to reduce its rate to 4 percent in the near future.

So bond prices can be affected by expected rate changes as well as actual rate changes?

You’ve got it.

But investor expectations of how interest rates could change can be influenced by all sorts of factors, can’t they?

Yes. They can, for example, be affected by economic growth and inflation. And these, in turn, can be affected by such things as consumer confidence, unemployment and labour productivity.

This makes bonds sound quite risky. I thought they were relatively safe.

They are relatively safe. But the key word is ‘relatively’. They are, for example, generally safer than equities (shares).

How can that be, if they’re both affected by economic and market factors?

For three main reasons. Turning first to government bonds, these, as the name suggests, are backed by governments and so are considered very low risk. Developed market government bonds are considered the safest investments of all because it’s extremely unlikely they would be unable to pay their bonds back in full. So the risk of default is very low.

And the second reason?

When it comes to bonds from companies, or ‘corporate bonds’, bondholders have a prior claim on a company’s assets than shareholders.

What does that mean?

Companies are owned by shareholders and, if a company folds, they receive whatever remains after the company’s liabilities have been paid off. If nothing remains, then the shareholders will get nothing.

But when a company folds bondholders become creditors and they have to be paid off before shareholders. That doesn’t mean bondholders will always be paid back in full when a company folds, so there’s still a risk of default, but it does make corporate bonds less risky than equities.

And the third reason?

Bond prices are typically less volatile than share prices.

You mean bonds go up and down in value to a lesser degree than shares?

Yes, generally speaking.

Why is that?

Because bonds provide relatively predictable income payments via their coupons. And the return of capital when the bond expires is more predictable than the sale price of equities (the share price). This makes bonds less risky than equities in general. As a result, they typically offer lower returns than equities.

Why do they offer lower returns?

Precisely because they’re safer. Higher risk investments offer higher potential returns as compensation for the higher risk you’re taking. In general the safer the investment the lower the return.

I think you’ve grasped the basics of bonds now. Next time we can consider why some bonds are riskier than others. And we can look at the more complex areas of bond spreads and yield curves.

Thank you!